DeFi is short for "decentralized finance," an umbrella term for a variety of cryptocurrency or blockchain financial applications that aim to disrupt financial intermediaries.
DeFi is inspired by blockchain, the technology behind the digital currency Bitcoin, which allows multiple entities to own a copy of the transaction history, meaning it is not controlled by a single, centralized source. This is important because centralized systems and human gatekeepers can limit the speed and sophistication of transactions and give users less direct control over their money. DeFi excels at extending the use of blockchain from simple value transfer to more complex financial use cases.
Bitcoin and many other digital assets differ from traditional digital payment methods, such as those used by Visa and PayPal, in that they remove all intermediaries from transactions. When you use a credit card to pay for a coffee at a coffee shop, a financial institution sits between you and the store, with control over the transaction, the power to stop or suspend it, and record it in their private ledger. With cryptocurrencies, these institutions are no longer in play.
Direct purchases are not the only type of transaction or contract overseen by large corporations; financial applications such as loans, insurance, crowdfunding, derivatives, betting, and more are also subject to their control. The elimination of intermediaries in all types of transactions is one of the main advantages of decentralized finance.
Mostdecentralized
financial applications are based on Ethereum, the second largest cryptocurrency platform in the world, which differs from the Bitcoin platform in that it is more easily suited for developing other types of decentralized applications beyond simple transactions. These more complex financial use cases were even highlighted by Ethereum creator Vitalik Buterin in 2013 in the original Ethereum whitepaper.
That's because the Ethereum smart contract platform - which automatically executes transactions when certain conditions are met - offers much more flexibility. Ethereum programming languages like Solidity are specifically designed for creating and deploying such smart contracts.
For example, a user wants their money sent to a friend next Tuesday, but only if the temperature rises above 90 degrees Fahrenheit, according to weather.com. Such rules can be written into a smart contract.
With smart contracts at their core, dozens of DeFi applications are running on Ethereum, some of which are detailed below. Ethereum 2.0, an upcoming upgrade to Ethereum's underlying network, could give these applications a boost by eliminating Ethereum's scaling issues.
Among the most popular types of DeFi applications:
- Decentralized Exchanges (DEXs): Online exchanges help users trade currencies for other currencies, whether US dollars for Bitcoin or Ether for DAI. DEXs are a hip type of exchange that connects users directly so they can trade cryptocurrencies with each other without entrusting their money to an intermediary.
- Stablecoins: a cryptocurrency that is pegged to an asset outside the cryptocurrency (e.g., the dollar or euro) to stabilize the price.
- Lending platforms: These platforms use smart contracts to replace intermediaries like banks that manage lending in the middle.
- "Wrapped" Bitcoins (WBTC): A way to send bitcoin to the Ethereum network so that the bitcoin can be used directly in Ethereum's DeFi system. WBTCs allow users to earn interest on the Bitcoin they lend through the decentralized lending platforms described above.
- Prediction markets: markets for betting on the outcome of future events, such as elections. The goal of DeFi's versions of prediction markets is to provide the same functionality, but without intermediaries.
In addition to these applications, new DeFi concepts have emerged around them:
- Yield farming: for experienced traders willing to take a risk, there is yield farming, where users browse various DeFi tokens in search of opportunities for higher returns.
- Liquidity Mining: when DeFi applications attract users to their platform by giving them free tokens. This is the most exciting form of yield farming yet.
- Compatibility: DeFi apps are open source, meaning the code behind them is available for anyone to see. Therefore, these apps can be used to "compose" new apps using the code as building blocks.
- Money Legos: To put the concept of "composability" another way, DeFi apps are like Legos, the toy blocks that kids click together to build buildings, vehicles, and so on. DeFi apps can be plugged together in a similar way to "money Legos" to build new financial products.
Lending platformsLending markets are a popular form of decentralized financing that connects borrowers with cryptocurrency lenders. One popular platform, Compound, allows users to borrow cryptocurrencies or offer their own loans. Users can earn from the interest on lending their money. Compound sets interest rates algorithmically, meaning that if there is a higher demand for cryptocurrencies, interest rates are set higher.
DeFi lending is collateral-based, which means that in order to borrow, a user must post collateral - often Ether, the token that powers Ethereum. This means that users do not have to reveal their identity or credit score to take out a loan, as is the case with normal, non-DeFi lending.
StablecoinsAnotherForm of
DeFi is the stablecoin. Cryptocurrencies are often subject to greater price fluctuations than fiat currencies, which is not a good feature for people who want to know how much their money will be worth in a week. Stablecoins peg cryptocurrencies to non-cryptocurrencies, like the U.S. dollar, to keep the price under control. As the name suggests, stablecoins aim to keep the price "stable."
Notable stablecoins include:
- Tether (USDT)
- USD Coin (USDC)
- Binance USD (BUSD)
- Dai (DAI)
Prediction MarketsOne of
theoldest DeFi applications on Ethereum is a so-called "prediction market," where users bet on the outcome of a certain event, e.g., "Will Donald Trump win the 2020 presidential election?
"The goal of participants, of course, is to make money, although prediction markets can sometimes predict better outcomes than traditional methods such as polls. Centralized prediction markets that have proven themselves in this regard include Intrade and PredictIt. DeFi has the potential to increase interest in prediction markets, as they are traditionally frowned upon by governments and often shut down when centralized.
Decentralized Finance FAQHow can
I make money with DeFi?
The value inherent in Ethereum DeFi projects has exploded, and many users have reportedly made a lot of money.
Ethereum-based lending apps, as mentioned above, allow users to generate "passive income" by lending their money and earning interest from the loans. Yield farming, described above, has the potential for even higher returns, but comes with more risk. It allows users to leverage the lending aspect of DeFi to deploy their crypto assets in a way that generates the best possible returns. However, these systems tend to be very complex and often lack transparency.
Is investing in DeFi safe?
No, it is risky. Many believe that DeFi is the future of finance and that investing early in this groundbreaking technology can lead to massive profits.
However, it is difficult for newcomers to distinguish the good projects from the bad ones. And there have been plenty of bad projects.
While decentralized finance activity and popularity increased through 2020, many DeFi applications, such as the meme coin YAM, crashed and burned, dropping from $60 million to $0 in 35 minutes. Other DeFi projects, including Hotdog and Pizza, met the same fate, and many investors lost a lot of money.
Moreover, DeFi bugs are unfortunately still very common. Smart contracts, while powerful, cannot be changed once the rules are written into the protocol, which often makes bugs permanent, increasing risk.
When will DeFi become mainstream?
Although more and more people are attracted to these DeFi applications, it's hard to say where they will go. Much depends on who finds them useful and why. Many believe that various DeFi projects have the potential to become the next Robinhood, attracting hordes of new users by making financial applications more inclusive and open to those who traditionally have not had access to such platforms.
This financial technology is new, experimental and not without its problems, especially in terms of security and scalability.
Developers hope to address these issues over time. Ethereum 2.0 could address scalability issues through a concept known as sharding. This involves splitting the underlying database into smaller parts that can be better managed by individual users.
How will Ethereum 2.0 affect DeFi?
Ethereum 2.0 is not a panacea for all of DeFi's problems, but it is a start. Other protocols such as Raiden and TrueBit are also in the works to further address Ethereum's scalability issues.
If these solutions come to fruition, Ethereum's DeFi experiments have an even better chance of becoming real products and possibly even going mainstream.
Bitcoin as DeFiWhileEthereum
is the top dog in the decentralized finance world, many Bitcoin proponents share the goal of eliminating the middleman in more complex financial transactions, and they have developed ways to achieve this with the Bitcoin protocol
.Companies like DG Labs and Suredbits, for example, are working on a Bitcoin DeFi technology called discreet log contracts (DLC). DLC provides a way to execute more complex financial contracts, such as derivatives, using bitcoin. One use case of DLC is to pay out bitcoin to someone only if certain future conditions are met, for example, if the Chicago White Sox team wins its next baseball game, the money will be paid to the winner.
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When you're in an unregulated space, it's critical to be aware of the risks
. What is Yield Farming? The Rocket Fuel of DeFi, ExplainedIf the terms "Yield Farming", "DeFi" and "Liquidity Mining" mean nothing to you, don't worry. We will enlighten you.
DeFi Analytics: How to Use Data to Make Smarter Investment DecisionsWhen it comes to DeFi investing, knowledge truly is power. A big part of that is reliable data, which is often hard to find.